Although we continue to use the term "DeFi", we should realize that it more accurately represents the concept of "on-chain finance", which includes both decentralized and centralized elements.

Original title: The USDC Depeg Implications on DeFi: Two Paths Forward

Written by: Igans

Compiled by: Frank, Foresight News

USDC depegging has raised significant concerns and questions about the future development of DeFi. Since the DeFi ecosystem is heavily dependent on USDC, it is crucial to evaluate potential solutions in the future.

I think we have two paths for the DeFi community to choose: redefine DeFi as "on-chain finance" or fully embrace decentralization.

1: Rename DeFi to “On-chain Finance”

DeFi’s reliance on centralized components like stablecoins, oracles, and Web2 infrastructure makes it vulnerable to potential government crackdowns.

USDC itself is considered the safest collateral, so much so that Compound v2 directly locks the value of USDC at $1.

Now we realize that trust in USDC ultimately relies on trust in the traditional financial banking system and the government. If the government really wanted to shut down (most of) DeFi, they could do it.

Currently, DeFi is meant to be decentralized and trustworthy at every level, so even one centralized component can affect the security of the entire protocol.

So by renaming DeFi to “on-chain finance,” the industry can maintain key advantages such as self-regulation, increased liquidity, composability, and a single source of data (irreversible transactions) while acknowledging centralization.

The benefits of "on-chain finance" will become increasingly apparent:

  • Increased liquidity (expanded buyer’s market);

  • Increased composability (new financial products);

  • Single source of data (reduced reconciliation costs);

Examples like FRAX show that projects can move in the direction of “on-chain finance” without fully embracing decentralization:

Frax Finance aims to get as close to the Federal Reserve as possible by applying for a Federal Reserve Master Account (FMA) (Foresight News note: the Federal Reserve Master Account allows holding US dollars and trading directly with the Federal Reserve), thereby getting rid of the limitations of using USDC as collateral and the risk of bank failures, and expanding the market value to hundreds of billions of dollars, making FRAX the closest thing to a risk-free dollar.

This means that even with some centralized components, projects like FRAX can still benefit from DeFi infrastructure.

This is because the DeFi ecosystem can maximize the trustlessness of the environment, thereby minimizing the need for human intervention.

Take Uniswap as an example: its code is designed to be immutable, which allows assets like FRAX to be traded on-chain without any censorship.

It is worth noting, however, that Uniswap’s user interface remains centralized and therefore vulnerable to regulatory pressure.

This highlights the delicate balance that DeFi projects must maintain between providing the benefits of decentralization and navigating the complexities of regulatory compliance.

Therefore, all elements and protocols of DeFi may never be fully decentralized or censorship-resistant, so viewing tokens like USDC as risky assets and DeFi as "on-chain finance" can help resolve this confusion and ethical dilemma.

2. Embrace full decentralization

The second option is for the DeFi community to remove centralized elements and become as decentralized as Bitcoin.

This would involve replacing USDC with censorship-resistant collateral like Bitcoin or Ethereum. Projects such as Liquity’s LUSD, Maker’s DAI, and Tornado Cash are typical examples of efforts in this direction.

Liquity’s LUSD

Liquity’s LUSD is a typical project that takes a more decentralized approach.

During the USDC crash, LUSD demonstrated its value as a safe-haven asset, providing stability during market turmoil, much like the Swiss Franc in the current traditional financial system.

However, we must recognize that even LUSD, with its decentralized nature, relies on price oracles, which can be manipulated in extreme cases.

This highlights the ongoing challenges and complexities faced by DeFi projects in pursuing full decentralization while ensuring security and reliability for their users.

Maker’s DAI

MakerDAO's vision for DAI is to build it into a fully decentralized and fair global currency.

To achieve this, Maker intends to phase out the use of easily seized collateral such as USDC to ensure greater resilience and a more secure foundation for the currency, which requires it to abandon its peg to the US dollar if necessary.

The recent alarm bells in the DeFi ecosystem over heavy reliance on USDC have prompted MakerDAO to accelerate this mission.

Tornado Cash

Tornado Cash proves that full decentralization is possible, albeit at a high cost.

As a successful privacy tool, Tornado Cash obfuscates transaction data for senders and receivers, and its total locked value (TVL) has reached $247 million.

Unfortunately, this level of decentralization proved costly for the project’s developer, who ultimately faced prison time for alleged money laundering.

The high cost of decentralization

The Tornado Cash case raises key questions for the DeFi ecosystem:

  • Are founders willing to take the risks that come with full decentralization?

  • Would users be willing to interact with fully decentralized applications if full decentralization puts their wallets at risk of being blacklisted?

While not every DeFi DApp is viewed as a threat by regulators, the possibility of regulatory intervention remains a permanent problem for the industry. In fact, the recent crackdown on stablecoins is driving DeFi toward decentralization.

As the DeFi space continues to grow, striking a balance between decentralization and compliance will be critical to the long-term success and sustainability of these projects.

The “D” in DAO

For example, imagine if the US government demanded that DAI be blacklisted.

How will Decentralized Autonomous Organizations (DAOs) such as Curve, which allows the creation of permissionless liquidity pools, respond to this request? What about Aave?

Faced with this dilemma, will Curve DAO choose to block DAI at the smart contract level or risk being blacklisted itself?

Finding a balance in the fully decentralized DeFi space is not an easy task, and projects must carefully balance their commitment to decentralization with the need to address potential regulatory challenges and maintain a sustainable ecosystem.

The two-way future of DeFi

In fact, there is a third option for the entire DeFi ecosystem.

DeFi may develop in two directions at once, just like the internet does today: while most users access the internet through regulated services, privacy-seeking individuals can use the dark web for increased anonymity.

DeFi protocols may exist at varying degrees of decentralization and regulatory compliance.

For example, the Uniswap interface could be censored, blocking access to specific tokens, but the community can create their own user interfaces because the code is immutable and non-discriminatory.

The future of finance

The recent USDC collapse has been a wake-up call for the DeFi community, as the risks stem from traditional financial banks, making it clear that DeFi is not as decentralized as we once thought.

However, the term "DeFi" has become deeply rooted in people's minds and is unlikely to be easily replaced.

Nonetheless, DAOs must stop perpetuating the fantasy of complete decentralization and start acknowledging the reality of the situation.

In fact, although we continue to use the term "DeFi", we should realize that it more accurately represents the concept of "on-chain finance", which includes both decentralized and centralized elements.

Only by embracing this understanding can the DeFi community work towards building a more resilient and transparent ecosystem.